Shanghai Dazhong Public Utilities(Group)Ltd (SHSE:600635) Seems To Use Debt Quite Sensibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Shanghai Dazhong Public Utilities(Group) Co.,Ltd. (SHSE:600635) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Shanghai Dazhong Public Utilities(Group)Ltd

What Is Shanghai Dazhong Public Utilities(Group)Ltd's Debt?

As you can see below, Shanghai Dazhong Public Utilities(Group)Ltd had CN¥8.10b of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CN¥3.57b in cash leading to net debt of about CN¥4.53b.

A Look At Shanghai Dazhong Public Utilities(Group)Ltd's Liabilities

Zooming in on the latest balance sheet data, we can see that Shanghai Dazhong Public Utilities(Group)Ltd had liabilities of CN¥8.44b due within 12 months and liabilities of CN¥4.31b due beyond that. On the other hand, it had cash of CN¥3.57b and CN¥486.1m worth of receivables due within a year. So it has liabilities totalling CN¥8.69b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of CN¥10.5b, so it does suggest shareholders should keep an eye on Shanghai Dazhong Public Utilities(Group)Ltd's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

As it happens Shanghai Dazhong Public Utilities(Group)Ltd has a fairly concerning net debt to EBITDA ratio of 6.4 but very strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Importantly, Shanghai Dazhong Public Utilities(Group)Ltd grew its EBIT by 41% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is Shanghai Dazhong Public Utilities(Group)Ltd's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Shanghai Dazhong Public Utilities(Group)Ltd recorded free cash flow of 38% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Shanghai Dazhong Public Utilities(Group)Ltd's net debt to EBITDA was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. We would also note that Gas Utilities industry companies like Shanghai Dazhong Public Utilities(Group)Ltd commonly do use debt without problems. When we consider all the factors mentioned above, we do feel a bit cautious about Shanghai Dazhong Public Utilities(Group)Ltd's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 4 warning signs with Shanghai Dazhong Public Utilities(Group)Ltd (at least 3 which don't sit too well with us) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.